Accounting Fraud Is Still Widespread Among Chinese Companies

With the renewed enthusiasm shown by the market for new listings from China, one would assume that investors had turned the page on all the claims of accounting fraud over the past few years.

But do so only at one's own risk.

There are still many U.S.-listed Chinese companies with the potential to be hit with accounting fraud that investors do not yet know about, at least according to one China-focused hedge fund manager.

Bing Lin, portfolio manager at Hong Kong-based $1.4 billion Keywise Capital Management, warns that the cases of accounting fraud among Chinese companies made famous by Muddy Waters' Carson Block might just be the tip of the iceberg.

"Based on my experience and observation, I think there is still widespread accounting abuse among listed [Chinese] companies, even some large ones," Lin told me during an interview in Hong Kong.

Lin wouldn't reveal their names, but says there are a number of common practices of misconduct. The first is revenue recognition. Lin says he sees some companies booking sales on a gross revenue basis, and therefore massively inflating their revenue.

Unfair related party transactions, such as acquisitions, are also common. Management may be paying inflated prices to a small business that's related to a relative or friend.

That's why Lin thinks this year will be good for long-short hedge funds like Keywise, unlike last year when almost all short trades were facing losses.

Aside from shorting those companies with abusive accounting practices, Lin is also targeting other companies to short. What kind of companies? Those whose business models are becoming obsolete, such as in the education sector, where online businesses are taking market share and profit from the offline business.

Another type of ideal short is companies that are engaged in other business beneath the surface. Some companies may say that they are in the technology business, but in reality, they are channeling money into real estate.

"The key is to read the small print in their securities filings. Not a lot of investors are paying attention to this, so this could be very good short opportunities too," Lin says.

To read the complete interview, click here. Click here to see other interviews with China-focused hedge fund and private equity managers.